Predicting Market Extremes Using the Put/call Ratio
The vast majority of forex traders concentrate their activities into the spot market. Here contracts are settled in a short time, currencies change hands swiftly, and any imbalances are rearranged in a short period of time. But forex trading is not limited to the spot market. Currencies are traded in the commodity futures market globally, and option traders are important participants of the market too. Indeed, around 8 am and 10 am NY time the settlement of option contracts fuels some of the most frantic activity on a usual trading day.
In light of the importance of the option market to forex, some resourceful traders have been making use of the put/call ratio of option contracts for predicting market reversals, and extreme values. Since the reader may not be very familiar with the options market, let’s take a look at what puts, calls are before continuing our discussion and examining how these values can be used to create a strategy.
A put is an option contract between a buyer and a seller where the option seller agrees to grant the option buyer the right, but not the obligation to sell an underlying asset in exchange for a premium received. A call (call option) is an option contract which gives the option buyer the right, but not the obligation to sell an underlying asset at a predetermined price in return for a premium. In short, the buyer of a put option gains the right to sell an asset, and to pocket the difference between the strike price and the actual price at which the asset is sold, if it is lower than the strike price. A similar situation is valid for the buy option.
If we were to examine market trends in the spot market, and compare them with developments in the option market, we’d find out that the two usually match each other closely. For example, when the market is in a strong downtrend, the amount of outstanding puts would rise significantly as traders flock to buy more of them, and the ratio of sell-side contracts (puts) to calls would rise significantly. As the price registers lower values in quick succession, we’d discover that the put/call ratio would reach very high values, and we could use this knowledge to enter counter-trend positions in the spot market in anticipation of a trend reversal.
Let’s see this with an example. Suppose that the EURUSD falls from 1.35 to 1.25 in a period of six months, and at the same time the put/call ratio rises from 0.5 to 0.8. First, we’d compare 0.8 to past extremes; in the past did such high put/call ratios precede reversals? If so, how often did this happen? We could also analyze the options market action with technical tools and seek divergences or convergences, or any other technical phenomenon that would signal a reversal. And if we discover that the high 0.8 value is associated historically with strong reversals and weakening of a downtrend, we could purchase the underlying currency pair, and expect to make a profit from the transaction.
There are many possible ways of profiting from forex analysis. Combination of data derived from different markets can have great predictive power, and provide us with a strong and healthy profit multiplier if it is implemented successfully. Of course, the usual cautions about overleverage, and excessive risk taking are valid, but it’s indisputable that the value added by the put/call ratio is a great addition to any trader’s arsenal.
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